Wednesday, January 04, 2012

What are asset bubbles and why do they happen?

Tomorrow I'm going to go the American Economic Association's annual meeting, to interview for economics jobs. (For the uninitiated, most jobs that are specifically for new econ PhDs conduct interviews at this meeting, which is what most economists mean when they talk about "the job market.") One of the key elements of getting a job as an economist is to have a "job market paper," which is generally the first chapter of your dissertation, and which is what shows potential employers that you can do quality research. My job market paper is here in case you want to read it. I'm not going to spend a heck of a lot of time discussing the paper (that can wait until it's ready to send off to journals), but it gives me an opportunity to write a post I've been wanting to write for a while anyway, about the research that motivated my paper in the first place.

Prices go way up, then they crash back down. Look at any long-term plot of any asset price index (stocks, housing, etc.) and you're likely to see some big peaks like this. That's what I call a "bubble." It's also the definition used by Charles Kindleberger in his book Manias, Panics, and Crashes.

But the real question is why we care about bubbles. Some people believe that bubbles are merely responses to changes in expected fundamental value of an asset (the "fundamental value" is the expected present value of the income you get from owning an asset). According to this view, the NASDAQ bubble happened because people thought that internet companies were going to make lots and lots of profit, and when those expectations didn't materialize, prices went down again. This view is held by many eminent financial economists, including Eugene Fama, the most cited financial economist in the world.

If bubbles represent the best available estimate of fundamental values, then they aren't something we should try to stop. But many other people think that bubbles are something more sinister - large-scale departures of prices from the best available estimate of fundamentals. If bubbles really represent market inefficiencies on a vast scale, then there's a chance we could prevent or halt them, either through better design of financial markets, or by direct government intervention. For a discussion on theoretical reasons to believe or disbelieve that bubbles = departures from market efficiency, see this email exchange between Eugene Fama and Ivo Welch. Very good stuff.

But in the end, empirical reality has to have the last word. And here's the problem we run into when we try to answer the question by looking at the data: It's nearly impossible to know what fundamentals really are. So in 1988, Vernon Smith (now a Nobel laureate) had the idea of using lab experiments to study bubbles. In a lab experiment, the experimenter knows what the fundamental value is, so whether the price exceeds the fundamental can be known with a high degree of confidence.

So Vernon Smith and his co-authors put groups of subjects in a lab, gave them some cash, and let them buy and sell a computer-generated financial asset. The asset payed dividends to whoever held it, so its fundamental value was equal to the expected value of the dividends it paid (or less, since people might be risk-averse). So not only did the experimenters know the fundamental value of the asset, but the subjects themselves were told everything they needed to know to calculate the fundamental!

And guess what happened? Prices rose way above the fundamental value, and then crashed at the end of the market. Check out this graph of the prices from one of their experimental markets:

The black stair-step line is the fundamental value (it goes down, since the market has a fixed finite lifetime). The dots are prices at which subjects exchanged the asset. As you can see, prices went way above the expected value of the asset in periods 3 and 4, then crashed back down somewhere around periods 9 and 10.

You are looking at a bubble that is also a market inefficiency. It is real. It exists.

Now if we knew that the market in this lab experiment was the same as real-world financial markets, this graph would spell death for the Efficient Markets Hypothesis. Done. Kablooie.

But of course, we do not know that this market is the same as a real-world market. This market is 8 inexperienced college kids in a lab, trading about $200 worth of an asset that is very different from real-world assets, over a period of maybe an hour. Real-world markets are made up of thousands or millions of experienced traders trading trillions of dollars worth of assets, with plenty of time to make their decisions. In other words, the Smith, Suchanek, and Williams experiment does not instantly explode all of efficient-market financial economics, because it may lack external validity.

But if it does have external validity, it's the most important empirical result in all of financial economic history.

A lot of work has gone into figuring out whether the Smith-Suchanek-Williams result has external validity. On one hand, it's reliably true that when the same group of traders - or even part of the group - repeats the market 3 times in a row, there's no bubble. On the other hand, if you take those "experienced" traders and run the experiment with a different fundamental value process, the bubbles come back.

The Smith-Suchanek-Williams type experiment has been run with professional traders. It has been run with large numbers of traders. It has been run under various different market institutions - allowing short selling, using different kinds of markets, under various rules, etc. Always, the bubbles come back. As the list of "things that don't prevent lab bubbles" grows, so does the nagging feeling that this type of inefficient bubble may be a universal phenomenon.

But there is one critique of the Smith experiment that has never really been put to rest. What if subjects just fail to understand the fundamentals? Maybe subjects simply learn by doing. Maybe you can tell them the fundamentals, but they don't really understand and believe in the fundamentals until they've had some experience with seeing the dividends roll in. In fact, there is research to support this critique. For example, when you let the subjects watch the dividend process before they trade, or when you explain the fundamental value in a different way, the bubbles disappear.

Nobody is really interested in a bubble that only happens because subjects are confused. It's easy to confuse a bunch of college kids. So this critique has limited the degree to which the "bubble experiment" literature has turned the financial econ world upside down.

That's where my job market paper comes in, actually. My experiment was about determining demand for assets in experimental markets - i.e., figuring out why people buy assets, not just whether markets lead to bubbles. Instead of the normal market setup, where all the traders trade with each other, I had traders who simply watched the prices that were produced by such a market, and then let them trade at those prices without affecting the price (think of this as one guy sitting at home buying and selling on E*trade; he's too small to move the market, but we can learn a lot from watching how he makes his decisions).

And one of the things I did was to ask my subjects how much dividend income they thought they would get from holding a share of the asset (i.e., the fundamental value). So I was able to tell who understood the fundamental value and who didn't. So I could tell if people who understood the fundamentals would knowingly overpay for the asset.

And guess what? They did. Even people who understood exactly how much the asset was worth were overwhelmingly likely to pay, say, 60 yen for a share of the asset (the experiment was run in Japan), even when the most dividend income they could possibly get for it was only 40 yen. They gave up certain gains. (Why on Earth did they do this? Well, that's what the rest of the paper is about, and is a subject for at least two other long blog posts.) So this result really answers one critique of the Smith bubble experiments: understanding what's going on is not sufficient to make subjects act like the "rational arbitrageurs" in financial economics models.

Now, that's only one critique of bubble experiments. It's impossible to answer them all. But science is a process of excluding causes one by one. The more uninteresting causes of bubbles we exclude, the closer we get to finding whatever interesting causes may exist.

To sum up: If we believed that Vernon Smith type bubble experiments could reliably show us how real financial markets work, the finance industry would be falling over itself to do a billion lab experiments, and both business and government would have to seriously rethink policies that depend on markets being efficient (e.g., stock options for executives). But the jury is still out. Still, the bubble result of Smith, Suchanek, and Williams (1988) is one of the most important experimental findings in the history of economics, and a research effort to which I am happy to (attempt to) contribute.

36 comments:

I strongly disagree with this when it comes to housing. We know what service a dwelling provides (shelter) and we have a long history of the correlation between incomes and home prices. When home prices are going up at 10% a year, and incomes are going up at 3% a year, it doesn't take very long for things to get out of whack. A competent macroprudential regulator should be able to spot a housing bubble and squash it before gets big enough to damage the entire economy.

How would you compare what the investors do with your frequent suggestions that the government should invest in research, education, infrastructure, etc. etc. etc.?

How are you optimistic of your ability to pick the public sector "winners" and pessimistic of the ability of investors to pick the private sector "winners"?

What's the difference between investors making mistakes with their own money and the government making mistakes with everybody's money?

If taxpayers were allowed to directly allocate their taxes would bubbles occur in the public sector? What would happen if taxpayers "overvalued" public education or infrastructure or research? Would they ever overvalue national defense?

Your experiment demonstrates that you still don't understand how opportunity costs help ensure the efficient allocation of scarce resources.

I'm puzzled (particularly reading the email exchange to which you linked) that you all talk just about income and not about the rate at which that income is discounted. My understanding of the tech bubble is that the expected growth rate of dividends (which as a first approximation was in perpetuity) was high while the discount rate was low, so that they were very close, and the fundamental price of tech stocks was roughly infinity. Then in 2000 there was some shock that either slightly reduced the expected growth rate or slightly increased the discount rate (or both, perhaps feeding on each other), and the fundamental value went down from approximately infinity to some finite number. The shock is hard to identify because it's a very small shock, but it has a dramatic effect because it affects a denominator that is approximately zero. A lot of people lost a lot of money, but if they shock hadn't happened (or if it had been in the other direction), they would have made out like bandits, getting all those future dividends. (Or arguably, their hypothetical earlier selves that had lower discount rates have actually made out like bandits, provided they didn't sell their stock, since they are still going to get all the future dividends.)

Fair enough so far as it goes. Investors do like to play greater fool, and then of course there's Keynes: "Successful investing is anticipating the anticipations of others". So someone could be rational, understand the valuation model and its output and still overpay for an asset, if that someone felt they could predict the way the rubes with middling SAT scores over at State would overvalue the asset.

But the whole thing puts a foot wrong in the first place. 'Fundamental Value' is a unicorn. It doesn't, and in fact, can't exist in any way recognizable to people who bother with that phrase. Even if we ignore uncertainty over discount rates, which is absurd, the earning power of any asset is inextricably dependent upon economic relationships that are dependent upon asset values and hence polite company's received wisdom of what 'fundamental value' is at any particular moment (and such wisdom is nothing if not fleeting).

As Carville would say, it's the circularity stupid! (and no, housing is very far from exempt for any of an number of reasons, not least wages). It's the circularity and the feedback loop between credit, investment and asset prices that cause boom and bust dynamics in economies and capital markets, not wayward traders.

The latter are the vector. Uncertain perception of the unknowable, a.k.a. Keynesian Uncertainty, is the disease.

PS Eugene Fama... wow. There are none so blind as discredited Chicago school economists.

"My understanding of the tech bubble is that the expected growth rate of dividends (which as a first approximation was in perpetuity) was high while the discount rate was low, so that they were very close, and the fundamental price of tech stocks was roughly infinity."

FYI, discount rates don't explain the raft of corporate bankruptcies and the sudden stop of venture and angel finance to the most bubblicious sectors or the massive retrenchment of the corporate sector, (which in many ways continues, as does the conservatism of the emerging markets, whose bank runs took place two and three years earlier).

And it would have been quite a feat to get very high earnings growth out of tech companies that were valued based on sales because they produced nothing but red ink and had no business model, not least by way of market consensus. Truly this is one of those things where if you can't bring yourself to point out the emperor's birthday suit, there's not much help for you.

How about, and I'm just spitballing here, we find out what people who saw these events coming have to say before those who've grown increasingly detached from reality with every post-hoc explanation they're forced to conjure to hide their red faces? Heck, letting their voice into the economic discourse at all would be a big step in the right direction.

So far as that goes, Jeremy Grantham of GMO could be a good place to start. He has compiled a very long and highly statistically significant record of making successful asset allocation calls, i.e. calls on markets. I can assure you, their account of the facts on the ground before and since the TMT bubble bears no relationship to the story you appear to have heard.

Markets are nests of complex adaptive systems and the idea that they can be modeled is folly. That you may be able to create a simple model that results in asset bubbles does not mean that you have modeled how asset bubbles are created by a complex adaptive system. In the real world there is risk, Knightian uncertainty and ignorance that makes calculating fundamental value a hard enough problem that buying an index fund is the best approach.Kameheman's system 1 gets people into trouble in the short term. You need to read about Benjamin Graham's Mr Market thinking about Keynesian Beauty Contests.

In this discussion, you base fundamental value on the NPV of a dividend stream. How about something like crude oil - or any other commodity - which has no dividend stream?

Evaluation is based on a perception of resale value. Which leads directly to the greater fool idea.

The thing that strikes me in your experimental graph is the post bubble bounce that occurs during the collapse. You see it in your (unlabeled) NASDAQ chart, you see it in the DJI, post 1929, you see it in Brent crude right now.

" I'm puzzled (particularly reading the email exchange to which you linked) that you all talk just about income and not about the rate at which that income is discounted. My understanding of the tech bubble is that the expected growth rate of dividends (which as a first approximation was in perpetuity) was high while the discount rate was low, so that they were very close, and the fundamental price of tech stocks was roughly infinity. Then in 2000 there was some shock that either slightly reduced the expected growth rate or slightly increased the discount rate (or both, perhaps feeding on each other), and the fundamental value went down from approximately infinity to some finite number. The shock is hard to identify because it's a very small shock, but it has a dramatic effect because it affects a denominator that is approximately zero. "

As far as I can tell, you're basically assuming an external shock, with no evidence other than the outcome, because a certain theory requires that there be such a shock.

Also, IIRC, the discount rates in the late 90's should have been rather high, due to the Fed and due to the fact that there were a lot of opportunities for investments other than tech stocks. And as was pointed out by 1999, the expected growth rate of dividends could not explain the prices; many companies were priced as if they had 100% of becoming the only supplier (net and brick) in their field.

"But the whole thing puts a foot wrong in the first place. 'Fundamental Value' is a unicorn. It doesn't, and in fact, can't exist in any way recognizable to people who bother with that phrase. Even if we ignore uncertainty over discount rates, which is absurd, the earning power of any asset is inextricably dependent upon economic relationships that are dependent upon asset values and hence polite company's received wisdom of what 'fundamental value' is at any particular moment (and such wisdom is nothing if not fleeting). "

I'm afraid that you didn't understand the entire point of doing such experiments. The goal is to see if bubbles still happen in markets where the fundamental value is know; the answer is that they do.

T Griffin said...

"Markets are nests of complex adaptive systems and the idea that they can be modeled is folly. "

Not wishing to require more of a PhD project than is reasonable - mine didn't exactly change the world either - I think it's easy to understand why majorajam and T Griffen have doubts about the value of a research programme that seeks to study a social phenomenon completely outside the context in which it actually occurs.

Noah has to conform to the expectations of his discipline in order to get his degree and get hired, but reading the paper it is hard to avoid the conclusion that all the actual features of the problem have been stripped away in order to make it amenable to his methodology.

"I'm afraid that you didn't understand the entire point of doing such experiments. The goal is to see if bubbles still happen in markets where the fundamental value is know; the answer is that they do."

And what does that show Barry? The whole reason for controlling variables, such as lies at the core of this experiment, is to attribute phenomena away from those variables. Furthermore, Noah specifically says this in his post: "many other people think that bubbles are... large-scale departures of prices from the best available estimate of fundamentals." My pointing out that this framing "puts a foot wrong in the first place" doesn't miss the point. It is the point.

"Nobody is really interested in a bubble that only happens because subjects are confused."

But what if just half the money in the market is invested by people who are confused, or just understand little about finance? What if three-quarters, or ninety percent, or more, is controlled by people who, at least, have very insufficient understanding of bubbles? It takes a great deal of education and training about finance to really understand it, to really recognize a bubble, or an asset priced way above its fundamentals. This is not knowledge you're born with, and it takes a lot of time and work to obtain, time few people have. I know this, because I've taught finance and personal finance to thousands of students at the University of Arizona, and I've seen lots of survey data with lots of wrong answers to questions that should be obvious to anyone who's had finance 101.

The common response is that even if 90%, or 99%, of the market has little idea of what they're doing, that savvy 10% or 1% at the margin will keep buying (or selling) until they push the prices to an efficient level. It's profit, or NPV, maximizing for them to do so. But is it really?

My, reply, from a 2006 letter in "The Economists' Voice is this:

...One reason which was missing, at least explicitly, and which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.

at: http://www.bepress.com/ev/vol3/iss8/art3/

Betting all out against a bubble by a tiny minority can mean highly undiversifying your portfolio, or just putting too much money into higher risk assets (even if even higher expected return) and too little into safe to be expected utility maximizing, even for the 100% savvy.

Good luck at AEA. We could certainly use more people like you with the credential of tenure at a major university to get them heard and considered.

Great piece and I enjoy your work and your writing. You may be aware that I have done a bot of work anchoring the housing bubble to real world metrics beyond merely incomes (which is obviously one applicable metric). The others are rents, construction labor costs, construction materials, etc. On a real basis all of the inputs into housing were pretty much flat (but for a very slight uptick as the bubble reached its peak). Housing, nationally, was up over 80% in real terms from its inflection point in late 1997 to June 2006, its peak.

I am pointing this out for three reasons:

(A) A asset bubble is, by definition, a relative matter. Real appreciation in prices paid (not fundeaental value) requires an assessment of fundamental value that is anchored in something more concrete than the value of future cash flows (rents), because you would still need to anchor that present value to an alternative investment rate of some sort. But, on the other hand, EVERY systemic input fails to track bubble pricing, it is a pretty good indicator of the presence of a speculative bubble. I like to explain the peak of the bubble - and the math is almost exactly right on this - as homebuyers paying for the home's value as shelter, and then spending an equivalent amount on a way-out-of-the-money option contract on the houses future appreciation. Tracking the relative cost of that option is another way of assessing the presence of a bubble.

(B) Is is important to identify the actual asset that is bubbling - my work demonstrates that in the case of housing it was clearly not the cost of occupancy, or of the cost of construction, but rather the cost of the missing input - LAND. You can see that very readily in data gathered in both urban and suburban areas. And, not surprisingly, land being a leveraged asset on the way up - it has fallen far more precipitously than the value of homes. In some loacations returning to its alternative use value - farmland.

C)The bubble must be fed by something. Housing prices rose substantially in the 70's - but the feeder, with about an 18 month lag, was ultimately incomes. Ultimately parallel wage, price and asset inflation - or what I refer to as "sustainable inflation." In the instant case, the feeder was, of course, credit. Some price appreciation can be attributed to reductions in the cost of credit (legitimate reductions, not "teaser rates") but when the divergance becomes too massive to attribute to cost of money in a credit driven bubble, it is probably the real thing!

You need't have credit to drive speculation - but you need leverage. In the equity markets (think internet bubble) the leverage comes from the attribution of market value to trades in only a marginal portion of outstanding shares. Put artificial lockups on a large enough number of those shares and - voila - leveraged bubble.

"...the discount rates in the late 90's should have been rather high, due to the Fed and due to the fact that there were a lot of opportunities for investments other than tech stocks..."

Recent experience should make it clear that the Fed is not the primary determinant of the discount rates applicable to risky assets. (Otherwise, we'd be having a huge asset boom right now.) And other risky asset categories weren't exactly performing badly during the time of the tech stock boom. Safe yields have remained low ever since the bubble collapsed, which makes me think that the general discount rate was fairly low already (i.e. the global savings glut didn't happen overnight).

I think the key is accepting that what we call bubbles are an unavoidable component of the human economic experience, and that the economic system should be set up to be as robust to them (and other volatilities) as possible. The former British Prime Minister, Gordon Brown, is famed for his pronouncement that his government's economic policies had "ended boom and bust". Then 2007-8 happened and his credibility evaporated. Boom and bust is as old as the hills. It is (probably) an artefact of over-exuberance.

In claiming that boom and bust could be (and had been) abolished he might as well have claimed that we was the reincarnation of King Canuut, and that he could stop the tide.

On the other hand, it is possible to make societies more robust to these sorts of problems. For a start, if a bubble is built on debt-acquisition (e.g. 1929) its collapse will be more painful than otherwise due to counter-party risk, because of the resultant default cascade.

Andrew Haldane at the Bank of England wrote an interesting paper on the shape of financial networks and their various robustnesses and fragilities.

" I think that always there will be fluctuation around "fundamentals". But, is not possible that fundamentals change with fluctuations of market prices? is not impossible to catch up it? a moving target?"

Luis (and others), the whole point of this set of experiments was to show that bubbles can and do exist, even when the fundamentals are clearly known to the participants, and the timing is short and known.

" Barry, yes, fine, I agree. But, if there is no fundamentals? What is the fundamentals of gold? Nobody knows. It is pure speculation. The same for the houses, I don´t believe that rent is a fundamental."

What if we're really living in a simulation, and the program parameters are subject to change wihout notice?

Noah: "To sum up: If we believed that Vernon Smith type bubble experiments could reliably show us how real financial markets work, the finance industry would be falling over itself to do a billion lab experiments, and both business and government would have to seriously rethink policies that depend on markets being efficient (e.g., stock options for executives). "

To start with, there is no such thing as value, there is only price. This sounds odd, but it is demonstrably true. Similarly, quantum mechanics asserts that there is no such thing as location or momentum, there are only measurements. Of course, people rely on knowing locations and momenta just as they rely on knowing values.

How do we estimate the value of something? We look at prices. That's the major justification for things like eBay and stock exchanges, they generate prices. Since you want to buy low and sell high, you want to be able to anticipate future prices, but the very act of buying or selling can change the price.

It's a simple feedback effect. Once enough people anticipate a price increase or decrease, the price will rise or fall as if in confirmation. More and more people want to buy or sell, and this continues until the market clears, usually when some reactant, usually money, is depleted.

Was it a readjustment or a bubble? Prices follow a pattern of punctuated equilibrium with periods of relative stability and periods of wild variation. A bubble is basically a measure of overshoot, and that is an artifact of how we set prices. No one has to be irrational, and it is hard to imagine an economic system that allows for collective pricing action which does not produce bubbles.

(*) It is possible to construct a system with actual values, just as one can pump heat from the cold outdoors into a hot room, but this is a limited and artificial system.

Take a look at Colin Camerer (http://www.hss.caltech.edu/~camerer/ScienceInteraction06.pdf):

The canonical model in economics considers people to be rational and self-regarding. However,much evidence challenges this view, raising the question of when‘‘Economic Man’’ dominates theoutcome of social interactions, and when bounded rationality or other-regarding preferencesdominate. Here we show that strategic incentives are the key to answering this question.

Bubbles are the result of business projects that are haphazardly undertaken. There is a plan with an expected outcome. The housing bubble was caused by broker-dealer tactics, selling credit on commission to create a revenue stream that could be securitized, generating perpetual fees and profits. It was modeled after the credit card project with a twist, the loans were backed by assets.

With the exhaustion of qualified borrowers, the project was modified, loose standards of loan origination created debt inflation of assets, until the true impact of faulty loan origination was discovered, undermining the entire project. The structure of the lending vehicles generated a title (joke) wave of asset transfers, more than the market could process without debt deflation of asset value. Bubbles are simply business ventures undertaken poorly and on a large scale. Lenders were as delusional as borrowers as everyone was making money and the risks considered slight.

I read your excellent 'job' paper. I am sure you thought of this already, but you seem to indicate that the subjects of the experiment were told that the data set they would be trading against was from a U of M study conducted in June 2011. While i assume you did not tell them that it was to study bubble behavior (for obvious reasons), it is certainly possible that they would have assumed or even deduced that was the case based upon your description of the experiment. This could have led to bias in which the subjects guessed they were trading against a known bubble, thus completely confounding the result.Frankly, that is a more likely explanation of the result than the assumption of complete irrationality. I can think of many ways to control for this. did you do so?

Great Article. Bubbles exist. We are living in a period of great bubbles that the econ and fiance professions have been loath to admit and adopt policy towards. Here we have a newly minting economist onto a good solid subject. Godspeed and success.